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Bumpy times ahead for financial markets?

Summary: It’s a tough climate for traders right now with a gloomy global economy, weak returns across the board and whispers of another recession on the way. So what assets have historically traded well during economic downturns? And how can you ensure you invest wisely?

While it is always important to maintain a carefully thought out investment strategy, balancing risk and reward, in tough economic times it is especially important to be protective and selective with investments. We look at the details behind the economic headlines and assess where the silver linings are on the stormy clouds of the financial markets.

Assessing the market situation

One of our favourite indicators is the Saxo global credit impulse – the second derivative of global credit growth and a major driver of economic activity – and it is currently falling. The indicator now shows 3.5% of GDP versus 5.9% in the previous quarter. Additionally, half of the countries in our sample, representing 69.4% of global GDP, have experienced a deceleration in credit impulse. With some notable exceptions such as the US, Japan and the UK, lower credit impulse is mostly observed in developed markets, while emerging markets experience a significant increase in the flow of new credit during economic downturns.

The message therefore from the slower credit impulse is that growth and domestic demand are headed for a slowdown, unless the world’s largest economies launch a massive coordinated intervention this year, which we believe currently to be quite unlikely.

We see further data confirming the slowdown and risk of higher recessionary pressures. South Korea, which serves as a good proxy for global trade and global growth, is experiencing very negative data. Industrial output fell -1.7% in November versus the -0.2% expected by the consensus. This is a warning signal for the global economy.

Where to now with equities?

Following the 9.2% decline of the S&P 500 in December, which caused many equity traders to become a bit nervous about the market, our main message during this period is to maintain a defensive strategy, favouring minimum volatility factor over pure equity exposure. Historically there are incidences of large declines in the S&P 500 leading to additional declines in the following six months – as we outlined in our Quarterly Outlook for Q1 – so it is possible that we may see more negativity in equities during this period. However, it’s also important for investors to remember that inverted yield curves don’t cause bear markets, stocks go down in anticipation of a recession, which is what believe we have experienced at the end of 2018 and in early 2019.

Quantitative tightening has led to higher volatility and more downward pressure on the equity market. The equity market risks are high, but we believe a lot of the bad news has already been priced in by the decline in the market valuation.

Since January, the US market’s PE ratio has fallen to 15.4 times, which is a healthier level. And, since October’s correction, the S&P 500 is less dependent on the performance of the FAANGM tech stocks (Facebook, Apple, Amazon, Netflix, Google/Alphabet and Microsoft). We believe earnings growth will be back down in single digits around 6% in the coming period, but it is still an honorable performance after years of very strong earnings. The main question mark going forward is very much linked to the Fed’s monetary policy and what their next move may be.

Assets that trade well in an economic downturn

Looking at historical records of equities performance we can see that consumer staples stocks have held up best out of any sector during hard times, the logic being that these companies are going to continue to perform as consumers will continue to need to purchase their products regardless of a recession. And the data shows the truth in this theory. During the 1995 dot-com crash, the consumer staples sub-index was +28% in comparison to the S&P 500 which was -34%. Again, during the global financial crisis, the same sub-index was +6% versus -25% for the S&P 500.

Keeping an eye on the US dollar during times of economic downturn is also a good idea. A fall in global trade – measured as world exports – especially due to higher protectionism, often implies a higher US dollar since investors are looking for safe havens. The US dollar is often considered a recessionary hedge because, as the world’s reserve currency, the rest of the world must buy US dollars when banks and companies deleverage. The year has begun with a weaker dollar but if concerns about the US and global growth outlook are proven to be well-placed there is potential for some steep rallies at times, just as we saw during the global financial crisis.

Gold keeps on shining

Keeping a balanced portfolio of trades is considered a healthy approach to investing, even during economic good times. However, during a downturn it is even more important. Just like the old saying goes, don’t put all your eggs in one basket! Multi-asset trading is one such way to spread your investments and manage risk wisely which is why Saxo Bank offers trading on more than 35,000 instruments from one account.

One asset that never loses its glow in times of economic downturn though is gold. The data shows that gold beats the S&P 500 during hard times due to its negative correlation to stocks. And just last year we saw gold reemerge as a strategic asset which serves as a US dollar hedge to mitigate the risks linked to the US budget deficit and as an asset to face higher global risk to growth.

Gold recorded its best month in two years in December as renewed demand was sparked by concern about the state of the global economy. Another indicator of the move to gold is that hedge funds turned long on gold in early December last year after having traded it from the short side for six months.

While there’s much turbulence around these days, and traders should take caution to protect their investments, we also believe that good opportunities remain for the wise investor.

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